Article excerpt

There are many ways to measure the impact of monetary policy on the economy: the growth of the monetary aggregates, bank lending and credit growth, the shape of the yield curve. And practically everyone keeps a close eye on the stock market. But Wall Street is no longer reacting in predictable ways to changes in monetary policy.

Consider that the value of IPO's plummeted the first five months of 2001 to $12.3 billion from $38.3 billion during the first five months of 2000, yet there was a significant stock market rally during April and May. The depressed NASDAQ raillied by over one third. The level of trading activity also has expanded this year. In the cas of technolgy, trading velocity was 373 percent during the first four months of the year compared to 257 percent during 1996.

The rally in the equity market against a backdrop of increasing velocity in share turnover has resulted from the rapidly growing influence of hedge funds on the market. During the past two years, there has been a dramatic expansion in both the number of U.S. hedge funds as well as the assets under their control. Brokers estimate that the hedge funds now have $500 billion spread over three to four thousand firms and that a new hedge fund is being launched every day. The capital base of the hedge funds is also changing. In the past they derived their capital primarily from wealthy individuals. Now there is a large flow of money coming from pension funds and other tax-exempt entities, which are not vulnerable to the high tax rates applied to short-term trading profits.

The dramatic growth of hedge funds is changing the behavioral response of the equity market to monetary policy. In 1999 and early 2000, the hedge funds were primarily long on the market and thus helped to drive prices sharply higher when monetary policy was accommodative because of concerns about the risk of Y2K disruptions in the economy. When monetary policy finally caused the market to correct, the hedge funds began to short the technology sector and drove it sharply lower. This selling pressure persisted until March-April when Fed easing became so aggressive that the market stabilized and the hedge funds began to curtail their short positions. The big stock market rally during late April and May resulted overwhelmingly from the hedge funds reducing their short positions.

Hedge funds also have emerged as the dominant players in the rapidly growing convertible bond market. They are attracted to the market because it provides opportunities for arbitrage with the equity market. As a result of hedge fund demand, the convertible market has expanded to a value of $187.5 billion from $154.7 billion one year ago and $128 billion in 1998. While there is no precise way to measure the hedge fund share of the market, traders estimate that it is about 50 percent. Hedge funds have been able to establish such a large position because the banks typically give them leverage ratios of 7 to 8 for convertible bond positions. On the basis of such ratios, the hedge funds could dominate the market with only $15 billion of equity capital.

Hedge funds have a long history of collaborating with central banks and ministries of finance to manipulate markets. Japanese officials have long given private guidance to major hedge funds in order to influence the yen/dollar exchange rate. The famous Soros attack on the pound during September 1992 was inspired by the Bundesbank itself. In the week before Black Wednesday, Bundesbank officials had told Soros consultants that they wanted the pound out of the ERM. They even provided confidential information about Italy's dwindling foreign exchange reserves to encourage a devaluation of both the lira and the pound. Alan Greenspan does not appear to have a personal relationship with the hedge funds comparable to the one which the Bundesbank once enjoyed with Mr. Soros, but there is little doubt that the hedge funds are emerging as an important conduit of monetary policy. …

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